The Telegraph
Since 1st March, 1999
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- Short of a miracle, oil prices will remain high, taxes or no

A news item, 'Oil Pressure at Bursting Point' (The Telegraph, July 23, 2005), alleges that the oil refineries incurred losses during the first quarter of 2005-06. This comes hard upon the heels of the price revision of June 21, 2005 as well as reports that other operators will share the deficit arising from the subsidized prices of kerosene and LPG. Indian retail prices of petrol and diesel exceed world prices, while the Oil and Natural Gas Commission receives no more than the internationally ruling price for the crude oil it supplies. Why then are the refineries losing enterprises'

To answer this question, we need to understand the salient features of the administered price regime for petroleum, which, despite announcements to the contrary in 1998, continues to exist even today. Two aspects of the price scheme arrest our attention. The first relates to profit accounting and the second to economic efficiency.

Note, to start with, that crude oil is either domestically extracted or imported, primarily by the ONGC, which receives, according to figures prevailing in the year 2000, around 77 per cent of the international crude oil price for its supplies to refineries. The remaining 23 per cent of the price transfers to government coffers to maintain the so-called oil pool account and is used to protect the shortfall in retail revenues arising from the subsidy on kerosene and LPG.

The profit from refining and marketing is best captured in terms of a simple numerical example. Suppose that ONGC supplies Rs 100 worth of oil, valued at the ruling world price. Of this, it receives Rs 77 as actual revenue, the remaining Rs 23 accruing to the state. Refineries, however, pay more than Rs 100 for the crude oil they purchase, since the gross value of ONGC's sales includes customs duties. Let us assume that these are fixed at 10 per cent and the refineries' expenditure amounts to Rs 110. To keep the arithmetic easy, we will pretend that this is their only cost of production.

The profit earned from refined products sale in the retail market, however, is fixed by decree. In reality, it is specified as a rate of return, but for the sake of transparency, let us say that a ceiling of Rs 30 is imposed on the total allowable profit from refining and marketing. Thus, the retail sales revenue is capped at Rs 140.

The refineries produce, let us say, 20 units of petrol and 30 units of kerosene. The administered retail price of petrol is (say) Rs 3 per unit and that of kerosene Rs 2 per unit. At these prices, the revenue generated will be Rs 120, which falls short of the targeted figure of Rs 140 by Rs 20. The deficit is made up from the oil pool account, which, recall, has a balance of Rs 23 in the example.

Consider now a giant 50 per cent leap in the international crude price so that the value of ONGC's supply increases to Rs 150. The escalation is not absurdly high, given recent price trends. The government receives Rs 34.5 as its 23 per cent share and the refineries pay Rs 165 for crude purchase, inclusive of the 10 per cent duty. With unchanged retail prices, the refineries will now register a loss of Rs 10.5. With only the kerosene price unchanged, the price of petrol should rise by 17.3 per cent to Rs 3.52, for refineries to merely break even. And to keep earning a profit of Rs 30 as before, the retail price of petrol must jump by 66.6 per cent to Rs 5, which, needless to say, is politically infeasible. Consequently, either the refineries have to sacrifice profits, or the profits of the entire oil sector call for redistribution. This appears to be a partial answer to the question posed at the very beginning.

The example ignores the fact that there are excise duties and sales taxes on petrol. The prices that are paid in the market include these and create a wedge between the price received by the refineries and the ones paid by the consumers. As already noted, the retail prices are higher than in the rest of the world. The profit calculation above indicates, on the other hand, that the price received by the producer may be less remunerative than what prevails elsewhere. An implication of this observation is that the latest escalation in petroleum prices benefited the government through increased excise and sales tax receipts and hurt the refineries through reduced profits. And that is surely a paradox, for the government has asked others to share the loss, while it has retained all its gain.

Now to the second aspect of administered prices, the one concerned with economic efficiency. Efficiency needs to be considered from the point of view of producers as well as consumers. The producers' story is straightforward and traceable to traditional tariff analysis in the theory of international trade. To promote domestic infant industries from cut-throat world competition, economies often distort prices of specific commodities by raising them above world prices. In case of Indian refineries, the effect of price distortion is all too evident. Even as its import of 45 million tons of crude in 2000 exceeded the domestic production of 32 million tons, its net import of finished petroleum products (including kerosene and LPG) was as low as 12.17 million tons and it was actually a net exporter of naphtha. This means that the administered price policy was successful in protecting the refineries. The reduced profitability issue noted above, however, could well negate this benefit in future.

The consumer side of the story is darker. Even when producers gain, basic trade theory tells us that a tariff-distorted equilibrium is socially inefficient. Higher domestic prices of petroleum imply that consumption at world prices would be budgetwise cheaper, leaving a surplus to be spent on other commodities. The inefficiency turns particularly painful in the case of petroleum. A rise in petrol prices pushes up the prices of most other products in the economy, since goods need to be transported across the nation, an activity that uses petrol as a major input. It is generally observed, however, that incomes of the better-off sections of society are positively linked to prices. Business passes on increased costs to customers, organized workers receive dearness allowances. Hence, the higher prices hurt them less than the poor, whose fixed incomes offer little relief from price escalations. Thus, a policy of administered increases in the domestic petrol price above the world price messes up the poor man even when kerosene price is left undisturbed. Worse, the rich remain effectively protected.

Can the situation be corrected by a withdrawal of taxes in the oil sector, leaving prices to be determined by market forces' In October, 2004 the left parties had suggested a reduction in customs duties. The budget for 2005-06 did bring them down from 10 per cent to 5 per cent. It appears, though, that the world price of crude rose to a disproportionately higher level, thereby landing the oil companies in trouble. Thus, even if the government were to eliminate taxes on oil, there is no guarantee that retail prices would stay low. India's crude reserves are around 650 million tons which, given the current rate of consumption, is expected to last another 20 years. The world's reserves too are likely to be exhausted in 60 years. It is not unrealistic to assume that crude prices will skyrocket in coming years.

Rather than foreign exchange, it is oil scarcity itself that will soon ration out oil demand. Short of a miracle, the dream of low oil prices will remain unfulfilled, taxes or no taxes. It is time that policy-makers woke up to the longer-run objective of discovering alternative energy sources. These activities, if any, are the ones that merit subsidization.

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